Video Transcript: The Financial Crisis and the Death of Macroeconomics | Joseph T. Salerno

My topic is the financial crisis and the death of macroeconomics. The topic  reminds me of an old joke: a Western observer is at a Soviet May Day parade  back in the 1980s, and it's the spectacle is overwhelming. The parade begins  with crack divisions of Red Army troops, followed by battalions of these very  mighty tanks. After which come huge long-range field artillery, rows and rows,  followed by the nuclear missiles, okay, that are gleaming in the sun. After that,  there's a small group of men, not in step at all, sort of puny, undistinguished looking, in ill-fitting suits. And the Western observer is puzzled, and he turns to  his Soviet hosts and he says, "Who or what is that? And they and they respond,  well, that's our most terrible and destructive weapon. Those are economists.  Well, those are our macroeconomists in the United States. Okay. All right. So I'm here to to to support Gary North what he said yesterday in trumpeting the silver  lining amid the gloom the gloom and doom about the financial crisis. After a long and disreputable history of about 300 years, in my four words, macroeconomics  is finally dead. As as as Gary pointed out yesterday, its leading leading  proponents simply do not know what to do anymore, and they've said so.  They've said this in in so many words. In fact, as Murray Rothbard, he actually  Murray's always been very was always very insightful. And and back in the  1980s, after the short-lived sort of attraction to monetarism died out because  they had had misforecast a recession that never occurred in 1984, 85,  macroeconomics was really dead from the neck up. That was Murray's term.  Okay, so it's really since the 1980s, macroeconomics has been a zombie  discipline, and I'm hoping that this crisis will finally put the zombie in its grave.  So let me just give you a very short paragraph on where macroeconomics came from. Where where did it come from? Okay, most people think it started with  John Maynard Keynes. People that are a little bit better informed talk about  Irving Fisher as a true father of macroeconomics. He first came up with the  quantity theory formulated in an equation. But really, macroeconomics is a is a  crackpot doctrine that came to life in 1705 in a very slim book entitled "Money  and Trade Considered, with a proposal for supplying the nation with money. The  author of the book was a Scotsman. His name was John Law. He was a  notorious character who was known throughout Europe as a gambler,  philanderer, schemer, and escaped convict who had killed a man in a duel in  London? He was also the first central banker. True. In 1716, Law became the  director of the Royal Bank of France and immediately enacted the principles set  out in his book. In four short years, he created a massive inflationary bubble that left the French monetary system in ruins when it when it finally burst, that was  the first macroeconomic crisis. There were many more to come. I'm hoping that  this one, the current one, will be our last. Okay. So now what I want to do is to  set out the dimensions, briefly outline the dimensions of the financial crisis, and  argue that it really is worse than we think, because it brought about a great deal  of overconsumption, capital destruction, malinvestment, and impoverishment 

that still has not been revealed. So let me just talk first about the money supply,  because it always starts with the money supply. Macroeconomics is simply the  policy conclusion that spending more money can cure anything. Okay, and that's it's been put in different language over the past 300 years, but that's that's the  germ of macroeconomics. So so let's start the dot-com bubble. Okay, it burst in  early 2000, leading to a recession in early 2001. The Fed reacted very  aggressively by lowering the target Fed funds rate. The events of 9/11 led the  Fed to ratchet up its expansionary monetary policy. From the beginning of 2001  to the end of 2005, the Fed's one of the Fed's monetary aggregates that I tend  to look at, which is MZM, increased by about $1 billion per week. They were  creating 1 billion new dollars in the American economy every week from 2001 to  2005 for five years. From the beginning of also, if we look at another one of their aggregates, m2, that increased by about $750 million per week. The monetary  base, which is completely controlled by the Fed, increased by about $200 billion  over those years, which was a cumulative increase of about 33% The Fed funds rate was driven down below 2% and then held at 1% for almost three years. Yet  inflation during this period was very moderate. Okay, the CPI fluctuated between about one and 3% However, since modern macro economists and central  bankers tend to narrowly focus on consumer prices to determine whether there's inflation in the economy or not. They believe that the monetary policy had their  monetary policy had succeeded in stabilizing the economy after the dot-com  bust. In fact, they congratulated themselves in the journals and papers that were produced by the various regional central banks, and they did this by claiming  that they had achieved over the past 20 years a great moderation. In fact, what  they had really done is to blow up a huge asset bubble that began in the 1990s  and didn't come to an end until 2007, 2008. So let me just give you some idea of the dimensions of this. Okay, this is the Fed funds rate, which starting in 2000  was quite high. It was over 6% You can see how it was pushed down and held  at 1% there for a long while, then Greenspan allowed it to rise, and that's when  we began to get the end of the housing bubble. Okay, and now it's been pushed  down again as the recession took place. The gray bar represents the periods of  recession. As recession took place, it was pushed down to between zero and  0.25% Here are the measures of the money stock. If you notice that both MZM  and m2 were just about $5 trillion in 2001 or so. Okay, today MZM is between  nine and between nine and $10 trillion, m2, so representing almost a doubling of the money supply, in in in about nine years. Okay, so massive increase in the  money supply. One thing you should notice is that both of of these aggregates  began to flatten out in about mid 2009. We haven't had much monetary growth  during that period. We've had qualitative easing, but now they're threatening us  with quantitative easing again. Qualitative easing simply means socializing the  financial system, okay? Trading government assets for for bad assets, taking  over financial institutions and so on. Quantitative easing simply means printing 

money. Okay, so we're going to be back to printing money again. Those lines  are going to start to rise again, very soon. And then this is consumer price  inflation, which shows that from 2000, from from 1990 or so, through except for  short periods, it fluctuated between 3% one and 3% You can see the, and then  then shot up right at as the recession hit. Okay, but for the most part, it was fairly moderate by historical standards. Now let's talk a little bit about the mortgage  market. As many Austrians pointed out at the time, the wildly expansionary  monetary policy ignited a boom in asset prices, especially in the real estate and  stock markets. Rates on 30-year conventional mortgages fell from fell sharply  from over 7% in 2002 to a low of 5.25% in 2003, and then fluctuated between  5.5 and 6% until late 2005. But this wasn't really the important story. The  important story, and what was more significant, was that one-year adjusted rate  mortgages, their rates plummeted from a high of 7.1% in 2000 to a low. There  were almost cut in half of 3.75% in 2003, and then they rose to about four 4%  and stayed there. But for 2004 and 2005, in addition, and importantly, credit  standards were loosened, and unconventional mortgages, including interest owned. Negative equity and no down payments mortgages proliferated. This  caused a rapid expansion of mortgage lending, and especially of subprime  mortgage lending. The subprime share of the mortgage market rose from  8.262% in 2000 to about 13.5% in 2005. So, yeah, tremendous increase in  subprime loans. Also, housing prices accelerated to double-digit annual  increases after after a short disinflation that we had during the 2001 recession.  That is, housing prices didn't come down in 2001; they stopped increasing as  rapidly as they had been in the 1990s. Okay, the housing boom soon turned into a bubble as as people's expectations lost all contact with fundamentals. People  who could not afford houses of certain prices were simply buying them because  they knew they could sell those houses at much higher prices in the future and  then move on to a high, an even higher priced house. By mid 2003, the stock  prices began to go up. We began to get a big bull market. Okay, let me just  again give you some of the figures here, some of the pictures. This is the 30  year mortgage rate, which was pushed sharply down from over 8% in 2000, and then fluctuated around 6% and then went up to around 7% right before the the  the bursting of the bubble. Housing prices, as you can see, rose tremendously  from January. If you take that as 100, they rose by 120, 120 percent in the top.  I'm sorry, by yeah, 120 percent in in in 10 leading cities, and by about 100  percent in in in 20 leading cities. Okay, and just to give you an idea of the rates  of change, housing prices were rising in 2004 and running up to 2004 by 15 to  20 percent every year. They were going up, okay. And again, this is for selected  10 and 20 cities. Okay, and and the housing crisis did not affect the housing  bubble. Did not affect the whole country. It affected some some larger cities and  metropolitan areas. Now, what's important is what was the effect on household  net net worth, because this is sometimes called a balance sheet recession, but it

was also a balance sheet bubble. The sharply rising stock and real estate prices boosted household net worth by over 23 trillion dollars during just three years,  from 2003 to 2006. This drove the ratio of household net worth to annual GDP to well over 450 percent. So let me just show you that. Well, this is just the  increases in the the Dow Jones. Okay, but okay, here's the household net worth. You can see that in 2002, it's about 40 trillion dollars. That includes all financial  assets and real estate assets minus the debts owned by households. So it went  from 40 trillion all the way up to 63 trillion in 2005 and 2006. Okay, it's 23 trillion  dollars. What did that do? That gave a tremendous impetus to people to begin  using their houses as ATM machines, and to engage in all sorts of luxury  consumption and consumption that, under more realistic circumstances and  under more realistic calculations, they would have never undertaken. So it set  off a huge consumption boom. Now historically, the percent of of total household net worth as a percent of GDP was about 350% If you go back all the way back  to 1992, it fluctuated about 350 percent between 300 and 350 percent.  Suddenly, notice how it sharply rises with the the bubble, the first bubble, the  .com bubble, 1995, rise up to 450, falls during our recession of 2001 back to  almost normal levels, and then shoots up to over 450 percent to 475 percent of  income. Okay, and then again later crashes, which we'll talk about. Okay, so I  can point out by comparison for over 40 years, from 1952 until the dot-com  crash began in the mid 1990s. The household net worth to annual GDP ratio  had held between 300 percent and 350 percent. After nearly falling back to this  range, as I pointed out in the recession of 2001, the Fed's monetary expansion  drove it up by 100 percentage points in a matter of three years. Okay. Created  $23 trillion of net worth, all of which was false, all of which was phony, all of  which misled people and misdirected their purchases, and caused what we call  an over consumption boom. So the enormous increase in net worth was based  almost solely on paper profits and phantom capital gains on households' real  estate and financial assets, people were misled by the inflation-bloated balance  sheets to cash out some of their home home equity and increase expenditures  on consumer goods and services. As we know, in the expression of the day,  people began using their houses as ATM machines. Households financed the  increased spending on boats, luxury autos, upscale restaurant meals, pricey  vacations, and so on through fixed dollar debt. This created a huge consumption boom as monthly real expenditures on retail and food services rose from an  average of 160 billion dollars per month between 2000 and 2003 to 180 billion  dollars through 2008. Okay, so there's there's a consumption boom, going from  160 billion. Okay, and actually you can see it going through the 90s. It's a huge  consumption boom. Okay, and it it was intensified after after after the recession  of 2001 by the Fed pouring a billion dollars a week into the economy, and by  people thinking that they were wealthier than they really were, this is what has  occurred during the boom and the bust. During the boom, you had falsification of

monetary calculation, so it's not just capital misdirected, but people begin to they begin to to misinterpret what prices are telling them. Okay, and and as we'll see,  it takes a long time to regain faith in the price system after you've had a crash,  after everything you've done, which seemed like the right thing to do given the  circumstances, suddenly turns out to be completely wrong. Here's what  happens: a personal saving rate. Why save if you're gaining trillions of dollars a  year in stocks in your 401k in your houses? So the saving rate in the U.S. fell  from around four or 5% even higher if you go back into the '90s. But by by 2000, it was around 4% It declined all the way to less than 1% in 2005. Okay, were  consumers just being profligate? Were they not worried about their futures? No,  they felt their futures were secured by the fact of this huge increase in net worth  that they could depend on for their old age, and fortunately, people came to their senses and began to save much more money out of their current accounts.  Okay, rising up to 7% and then 8% by the end of the recession. Okay, and by  the way, this troubles the Fed, but we have too much saving. Morons. Okay.  Okay. Let me just say a few words. The household debt. Thus, household  assets rose by 21 over 21 trillion dollars from 2003 to 2007, liabilities, mainly  home mortgages and consumer credit, increased by $4 trillion during the same  period. Okay, now the collapse from 21 trillion back by 21 trillion, of course, then  made this increase in fixed liabilities. The new $4 trillion that they had in fixed  dollar liabilities made it much more burdensome. Okay, one of the results of this  was that the year-over-year rate of growth of household debt nearly doubled  from 6% during 1997 to 11 percent for three consecutive years, beginning in mid 2003. Okay, so the household debt outstanding is up around 11% Okay, and  that's on the right axis. And when the boom came to an end in 2007, housing  prices, corporate profits, and markets plunged. The capital gains accumulated  since the mid 1990s were revealed to be an illusion. This is interesting.  Household net worth, okay, the value of your house and and your financial  assets of all Americans declined by $13 trillion, okay, or 20% during one year  alone, 2008. That $13 trillion is a figure exceeding the sum of the combined  annual GDP of Germany, Japan, and the UK. Okay, that wealth disappeared into thin air. It was actually never there. People thought it was there. Okay, this  brought the over consumption frenzy, which had begun in the mid 1990s, to a  screeching halt. All right, let me say a few words about the retail slump. One of  the most important features. The current recession in the U.S. has been the  exceptionally severe retail slump. In the old days during recessions, you didn't  have retail stores going out of business. You had construction companies. You  had steel companies laying off workers. You had interest-sensitive consumer  goods like automobiles cutting back. But you didn't have linens and things, or or  some of the other. In fact, let me let me just give you some of the qualitative  dimensions of this. The current retail Chrysler filed Chapter 11 on April 11,  followed by GM on June 1. This is in 2009. KB Toys, one of the largest U.S. toy 

retailers, sought Chapter 11 protection in December 2008, and announced that it was planned to close all of its 460 retail outlets. Circuit City, the second largest  electronic retailer in the U.S. declared bankruptcy and closed all 575 of its stores that year. Mid-sized electronics retailer Comp USA closed all 103 of its outlets.  Sharper Image, a novelty and electronics retailer, was also has also declared  bankruptcy. Linen and Things, the second largest home goods retailer in the  U.S. filed Chapter 11 and is liquidating its 371 stores. Fortuneov's, a leading one of my wife's favorites, a leading jewelry and home furnishing chain in the  Northeast, filed for bankruptcy, as did mid-sized furniture retailers Levitts and  Bombay, both of which are liquidating. Many more retail chains are scrapping  expansion plans and proceeding with massive cuts, or have done that, including Disney and Taylor, Footlocker, and many many others. You didn't have these  things happening in early recessions because you didn't have the massive  bubble that that that created all of this false wealth that people had reacted to,  and I had have some statistics here on the quantitative dimensions of the slump. I'll just I'll just read one or two of them for for December 2008, the year-over-year decline in current dollar sales was 11.1% and from January through July 2009,  these year-over-year declines fluctuated between 8.5 and 10.5% Now, what's  the significance of that? Well, except for two non-consecutive months during the  recession of 1990, 1991, in which monthly retail sales dipped slightly below zero in a year-over-year basis, one would have to go back to 1960, 61 to find  declines in actual dollars spent on consumption goods. Okay, during a  recession. Okay, retail sales also took an exceptionally real retail sales also took an exceptionally sharp plunge during this recession. They declined from 180  billion dollars on a monthly basis, which I talked about in 2006, 2007, to 160  trillion billion. Okay, if you compare this to the current recession, to all  recessions, all other recessions beginning with 1960-61, the monthly percent  change in real retail sales from a year ago fell by 8% for only three months. Out  of all the past recessions going back to 1960-61, you had real retail sales falling  for only three months, and that all happened in the mini recession of 1980, and  they weren't consecutive. By contrast, during the current recession, real retail  sales on a year-over-year basis have contracted by 8% for nine consecutive  months, which ended in 2009. Overall, they contracted; they were negative for  23 consecutive months. Okay. All right. Let me just jump ahead here. That  shows you the dimension of the something that no one expected, and that was  the the retail boom or boom and and slump. Okay, now I want to talk a little bit  about capital consumption, which I think is the fallout from all of this. The extent  of capital consumption and malinvestment that resulted from the housing boom  is revealed by developments in the Wilshire 5000 Total Market Index. This index  tracks the total dollar value of all U.S. headquartered equity securities with  readily available price data. Okay, so it's basically the total capitalization of all  the firms headquartered in the U.S. minus the the capital that was invested by 

bondholders. So it's it's it's using the total stock capitalization. It's using total  stock value as a as a proxy for the total capital of all our firms. After reaching a  high of 15.5,000,000,002,007, okay, the index collapsed and fell to a low of $8  trillion in 1997. So there, there you have almost $16 trillion, and fell all the way  to 8 trillion. Okay, it had since. Covered and has been languishing around  $11,000,000,000,000.11, and a half trillion dollars. Now, what does that mean?  The first time that the Wilshire 5000 reached 11,000, $11 trillion was back in  1997. What does that tell you? That there's been no capital accumulation since  1997. That any capital that was accumulated after that point was destroyed by  malinvestment, investing in wrong lines, and over consumption. People  consuming their capital, consuming their savings. Okay. And now we can talk a  little about the death of macroeconomics. It may happen that even the level of  wealth and income that that we think we have now is based on false  calculations, because the Fed and the U.S. Treasury, which is a fiscal agent of  the U.S. government, have used every tool at their disposal and even forged  some new ones in order to prop up housing and financial asset prices. Okay, so  we have a bunch of things here. Well, this is percent changes in the Wilshire you don't have to worry about that um the federal deficit see it way down there in the corner you probably can't the federal deficit uh for fiscal year 2009 was 1.4  trillion and is on target for $1.2 trillion for this fiscalyear. um and with trillions of  dollarss of deficits each year being for foreclosuredown the road as Gary North  pointed out yesterday the gross federal debt has risen from around $4 trillion uh  in well I'm sorry around $6 trillion in 2001 all the way up to nearly 14 trillion 10  trillion in addition to federal debt now. The gross federal debt um that's the gross federal debt the amount of the debt held by private investors okay 4 trillion is tell  by government agencies and that we don't have to worry about that because if  we have a just world or eventually we we bring about a world uh of of a free  market economy you can cancel all that debt that's held by government  agencies. but private investors hold 8 trillion four trillion of which is held by  Foreign investors, So we're on the hook to pay interest on on this debt and  eventually the principle the fed's attempt at qualitative easing which is as I said  is a euphemism for nationalizing the financial institutions has resulted in its  balance rising from 800 billion to 2.2 trillion just in the fall of 2008 very colorful  here so this is all of see the the blue is at the bottom the traditional security  Holdings government securities they added lending to financial institutions this is qualitative easing liquidity to key markets Federal fed agency debt mortgage backed Securities purchases okay so it jumped from under 1 trillion to um $2.2 trillion okay and the mar now the Market's not buying this I mean this hasn't this  hasn't got us got us back on track um despite all of the stimulus programs and  the alphabet soup of qualitative easing programs Taff tarp talf ppip fasp amlf so  on the US economy is mired in a stalled recovery um caused by what Gary  called broken confidence and Bob higs calls regime uncertainty despite the 

quantitative EAS easing and the qualitative easing the FED has done that the  FED has done and the stimulus programs the deficit spending no one is  willing to borrow and invest because they do not know the economic  consequences of all these programs andthe other government programs such  as cap and trade Dodd Frank Bill and ObamaCare that are scheduled to be implemented no one knows the the effects of this um there's a great graph by Steve hanky here um I'll I'll quickly describe it and give you one more graph and  I'll end um as hanky points out the FED has increased the money supply so it's increased its own the very bottom of of this rectang of this triangle the lower  triangle is from August of 2008 what you can see there is that the FED has  about $800 billion in monetary base and the money supply measured by M2 is  $7.8 trillion now that has grown from August 2008 to August 2010 or to June  2010 um the the base is more than doubled and the money supplies increased  from 7.8 to 8.6 trillion dollar however what has not grown what has shrunk is  borrowing is is is is is is the extent to which people are willing to take on new  debt this is what is stalling us um so Shadow banks that is the f Broad Financial  system um their the credit extended by that by by this sector has fallen from 16  trillion to 13 trillion um the international positions of of banks those US dollar  deposits outside the US has fallen from 13.2 trillion um to 12.2 trillion okay so  that's Fallen um and finally the derivatives okay the the um over-the-counter  derivatives have fallen from 684 trillion to 615 trillion so the FED is pushing  money out but the Market's not taking it the investors well let's put this way the banks don't trust the investors they don't trust the um businesses they don't believe that they don't have confidence that that that there's solvent business or  that that businesses out there have good plans for for investment the investors  themselves aren't taking the loans because they don't see profit opportunities  and they don't see profit opportunities because they believe that we're going to  have higher taxes because of the of all the programs that the government has  implemented as as well as as as as the pending programs that will be  implemented in the future as well as of course the the deficit uh and and the  huge debt that we're facing so the US credit triangle is is shrinking and the  Market's causing it to shrink okay and that's that's a good thing because entrepreneurs are stepping back and making sure that before they do anything  prices and costs are aligned properly that there are pro true prospects for profits what the FED has to do is to step away the government has to step away they  have to allow the adjustment to occur and this I think this last um graph shows  us um the death of macroeconomics okay as you'll notice I the black line is the  federal deficit okay um the the the red line is the Fed funds rate now as they  move down the defit gets larger as the black line moves down and the FED fund rates funds rate gets lower as as as a red line moves down that means that we  have more spending and more money creation but notice what happens to the  Blue Line every time the two the monetary policy line and the uh fiscal policy line

move down is that is as we get every time we get more deficits or greater  deficits and lower interest rates what happens to the Blue Line the  unemployment line goes up okay so everything they're doing is having the  opposite effect to to their intent or to their stated intentions in fact recently uh in  May in the a there was an article by University of Chicago Economist Harold  huig that pointed out that for every new dollar of government stimulus spending  there's a destruction of $3.40 of of of real output in our economy so um I'm  happy to report that um it looks like macroeconomics is on its last legs and that  you know hopefully it will be put in its grave we just have to say we knew this  was coming as Austrians we told you so here are the reasons okay and and  here are the data so thank you.